More Muscle, More Mandates for the Post-Reform Fed

The Federal Reserve Board, accused of failing to use its powers to prevent the financial crisis, is likely to emerge from the regulatory reform process as a more assertive regulator focused on anticipating the next systemic threat.

"The Fed will probably be more proactive in trying to deal with bubbles than they have in the past as a regulatory matter, not as a monetary policy matter," said H. Rodgin Cohen, a partner and the senior chairman at Sullivan & Cromwell.

The reform bill, which the Senate could pass today, would give the central bank expansive new powers, but also heaps additional responsibilities on it.

Under the bill, the Fed must write 54 rules, complete three one-time reports and write three new periodic reports. Within the first 18 months alone it must write new risk-based capital, leverage and liquidity requirements.

It is also now charged with conducting annual stress tests for systemically important companies, including publishing a summary of the results, implementing the Volcker Rule and jointly writing rules that force large banks to draw up "living wills."

The legislation may prove to be a double-edged sword for the Fed. It has argued that its authority was restricted during the buildup to the financial crisis, preventing the central bank from anticipating it or warding it off.

That argument is unlikely to work in the future.

"The power that the Fed will receive … does mean there will be greater pressure put on the Fed more generally to be proactive in making sure there isn't the next systemic failure, or there isn't the next meltdown in the financial system," said Satish Kini, a partner at Debevoise & Plimpton LLP. "It will be difficult for the Fed to contend it didn't have the authority and the power to do what it needed it to do. This is a fairly broad grant of regulatory authority to the Fed in a lot of different areas. That grant of authority comes with a lot of responsibility."

Once the bill is enacted, the Fed will have to tackle key issues within a short time frame. Chief among them will be the implementation of the Volcker Rule that bans proprietary trading and limits commercial banks' investments with hedge funds and private-equity firms.

The Fed will have six months to deliver initial language providing guidance for the transition period related to the rule. Though bankers have at least four years before the rule is fully in place (it is effective after two years, with a subsequent two-year transition period) many argued the market cannot wait to find out how the rule will be implemented. Under the bill, banks are banned from having more than 3% of ownership of a fund or private-equity firm, or having a total number of investments higher than 3% of their Tier 1 capital.

"The problem is you are making investments today, opportunities are there, and you don't want to make them if you've got to divest them," Cohen said. "You can't put everything into a deep freeze. You can't go into hibernation. It's not going to be acceptable to say to them, 'Well, it will be two years before we can tell you.' People can manage to rules, what they can't manage to is uncertainty."

Kini said the Volcker regulations "will be important rules because banking entities that have activities and investments will be looking to the Fed's rulemaking for guidance on what exactly the rules of the regulation will be for that conformance period."

It will also be required to draft new liquidity requirements and create new contingent capital instruments, which allow banks to quickly convert debt to equity under stressful circumstances. Along with the Federal Deposit Insurance Corp., the Fed must write rules governing "living wills" for systemically important institutions, which require companies to detail how they would be unwound in the event of a crisis.

It will also inherit thrift holding companies — previously regulated by the Office of Thrift Supervision — and act in its role as a member of an interagency systemic council, which is expected to dictate additional actions the Fed must take.

"There are a number of areas where the Fed will be stretching its muscles where it hadn't done before. Its purview will be much broader now," Kini said.

Soon after the bill is enacted, many expect the Fed to compile a list of the deadlines for rulemaking, and adding staff to ensure it has enough resources to comply with its new mandates.

"A lot of it in the beginning is taking stock, figuring out what's there and figuring out when you have to do things, and who's going to do those things to see where the conflicts are," said Oliver Ireland, a banking lawyer at Morrison & Foerster LLP.

One potential flaw is that many rules require input from multiple agencies. It remains unclear how well the regulators will work together.

The other test for the Fed will be figuring out how to manage its current set of duties, while tackling other major tasks and making sure it has enough human capital to do it all effectively.

Some said the central bank could be overtaxed.

"Where are all the people who will do the work needed to implement Dodd-Frank?" said Ernest Patrikis, a lawyer at White & Case LLP said. "It seems to me that the Fed staff has been running flat out."

Though nothing has been said about potential hiring at the Fed, it's likely the central bank will be seeking additional staff, he said.

Cornelius Hurley, a banking and financial law professor at the Boston University School of Law, agreed.

"You would think after all the dust has settled in the final bill someone in Congress would have asked the question, 'OK, regulators, here is the bill, here are all the rules and here are all the studies that are required. Do you have the resources to do this? Can you get it done and fulfill your ongoing obligations?' If the Fed, for example, doesn't have the resources, then what's next?" Hurley said.

While many agree that much of what the Fed will be doing is new, some observers are quick to note that the bill in many ways formalizes some of what has become part of the central bank's day-to-day practice the past two or three years.

"What the new law does is cast in stone some things the Fed has already been doing in response to the changed environment," said Andrew Freeman, an executive director of the Deloitte Center for Banking Solutions.

"For example, there is already a lot more thinking about systemic risk today, and this gets formalized by the creation of the new systemic infrastructure in which the Fed plays a key role," he said.

Even so, observers seem skeptical that the Fed will continue to be able to focus much of its energy on its routine tasks now that its attention will be diverted to new priorities.

Other regulators, like the Office of the Comptroller of the Currency, will face similar challenges.

Even with the need to move quickly, most observers said the process will take years.

"This bill actually doesn't represent the finish line, but represents the starting point," Kini said. "The exact contours that this bill will achieve won't be known until all of those studies and that rulemaking process is completed. We really won't know the shape of financial reform not until probably another few years."